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Capital goods: Do rising material costs hurt?

Commodity prices have been on a steady increase over the past few years, fueled by strong demand from China and other developing nations (including India). Not only steel, but also other materials such as zinc, copper, aluminium and nickel have seen their prices rise incessantly. In India's case, there has been a strong demand for these commodities not only in the infrastructure space but also in the manufacturing sector as companies have gone on expansion spree.

The capital goods sector is one such example where companies have increased their capacities in recent times in order to meet up with high demand for their products, especially from the power, energy and infrastructure industries. In this article, we will see whether the rising prices of raw materials have impacted the companies present in the capital goods space.

We have taken the companies from the BSE Capital Goods (CG) index under consideration. The companies comprising the same (the index) are catering to sectors like power generation-transmission-distribution, engineering services, construction, textiles, bio-fuels, defense and wind energy.

Below are some of the charts giving a visual perspective on how rapidly the metal prices have risen over the past few years.

Steel prices have risen at a compounded annual growth rate of 13.9% over the last six years while zinc and aluminium prices have risen at rates of 16.6% and 6% respectively during the same period. Nickel prices have risen at a much faster annual rate of 27.7% over this time period.

Impact on companies
One must be wondering on how the companies from the capital goods space have been coping up with the steep rises in the raw material prices. Or on how these price rises have been affecting the capital goods companies' profitability.

Interestingly, the margins of capital goods companies have not really been impacted by increase in the prices of these raw materials. This is because these companies have been able to offset these hikes by way of higher (and better) utilisation of resources and cost-cutting initiatives. As such, these companies have been able to steadily increase their margins during the course of time. As we can see from the adjacent chart, during the pre 'infrastructure boom' period i.e., before FY02, the companies did see some impact on margins on account of rise in raw material prices, among other costs. However, with a lot of emphasis given towards building and developing infrastructure, particularly in areas such as power, roads and telecom, the capital goods sector companies have been able to increase their revenues and profitability by improving on their efficiencies.

The consolidated revenues of these companies (which are part of the Capital Goods Index) have grown by 26.4% CAGR over the past 5 years, while their input costs have risen at a rate of 28.8%. Apart from the factors mentioned above, another reason why companies have been able to ramp up profitability despite rising material prices, is due to the price variation clause (that allows a company to pass on the increase in overall cost of a project to the respective client), as nearly all the engineering companies are following this practice (mainly in the domestic markets).

Conclusion
We believe that a strong momentum in infrastructure investment is set to continue in India over the next few years, though not exactly to the extent the government is targeting (US$ 500 bn of spending during the XIth five-year plan). This shall benefit capital goods companies, especially those with integrated operations, large scale and strong execution capabilities.

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